Weighted Average Cost of Capital

Topic Attempted: C

Synopsis

Prior to selecting which project to invest in, investors would assess the return of the project. Ideally, the weighted average cost of capital (WACC) serves as a project evaluation tool to ascertain the minimum rate of return required for the project. Investors would invest if the project’s rate of return is more than its WACC and vice-versa. This essay focuses on whether WACC is widely used in capital budgeting and some common practical difficulties associated with WACC.

Introduction

The WACC is the cost of capital that reflects the risk of the overall business, which is the combined risk of the firm’s equity and debt. It is estimated by multiplying the weight of each capital component in a firm’s capital structure by its component cost (see appendix 1). It is a common practice to use the WACC as the discount rate in capital budgeting. The two main applications of the WACC are: use as a discount rate to analyze proposed capital investments and to evaluate the capital structure (Baker & Powell, 2005).

Wide Application of WACC in Capital Budgeting

Berk, DeMarzo & Harford (2011) and Koller, Goedhart & Wessels (2010) claimed that employing the WACC method is intuitive and straightforward. Consequently, this method is most commonly used in practice for capital budgeting purposes in both private and public sectors despite the emergence of newer models and its practical difficulties (will be discussed in the next section).

In a recent survey conducted to determine the best discount rate used among the Fortune 1,000 Chief Financial Officers has indicated that WACC was the strong preference among the respondents that accounts for 83.2% among other methods (Ryan & Ryan, 2002). In another survey done by Truong, Peat & Partington (2008) to observe the capital budgeting practice of Australian corporations has shown that 84% of the Australian firms employ the WACC in their evaluation (see table 1).

Practical Difficulties of WACC

Shapiro (1979) and Hyung-II Jung (2008) claimed that there are legitimate limitations and problems in applying a weighted cost of capital to value investments. Alternatively, many researchers have proposed the adjusted present value (APV) and other extensions as a solution to overcome its limitations. The common difficulties that analysts encounter in employing the WACC are as follows.

Types of weights available to calculate the WACC

A frequent question that analysts will question in computing the WACC is which weighting schemes should be employed, that is, the book value or market value? Baker & Powell (2005) suggested that analysts could employ book value if no substantial changes have occurred